These are bonds in which the coupon is not remunerated in cash but by way of more bonds.
Companies which have cash flow problems issue such kind of securities and consequently by nature these instruments are unsafe.
Moreover, while temporary cash flow stress is kept away from, simultaneously more loan gets added on the balance sheet, of a company which is already into trouble. Hence, these products are typically for the high risk investors.
Principal – Protected Note (PPN)
PPN is a fairlycomposite debt product which aims at offering protection of the principle amount invested by investors, if the investment is held to maturity. Characteristically, a portion of the amount is invested in debt in such a way that it matures to the principal amount on expiry of the term of the note.
The balance portion of the original investment is invested in equity, derivatives, commodities and other products which have the potential of generating high returns.
Even though this is marketed as a debt paper, as it has descriptionalike to fixed income securities, it is a synthetic product constructed by financial engineering – mixture of debt and derivative structures.
Risk adverse investors get an occasion to invest in products with a likelihood of high returns, whilst at the same time; their downside is protected in PPNs.
It must be clearly implicit that principal protection does not mean lack of credit risk. Investors in PPNs are exposed to the credit risk of issuers.
Several Non-Banking Finance Companies (NBFCs) have issued PPNs titled Equity Linked Bonds (ELBs) or Commodity Linked Bonds (CLBs) in the past to raise capital. Some of these structured instruments are listed on Stock Exchanges.
Inflation – Protected Securities
Debt instruments as they are fixed income products run the risk of conveying negative real returns during high inflation periods.
Sometimes, the investors of debt papers are retired aged persons, who do not have other source of income. In such cases, it becomes enormouslysignificant to have returns beating inflation.
Inflation Indexed Bonds (IIB) are a group of government securities issued by the RBI which provide inflation protected returns to the investors.
In India, Inflation indexed bonds have been launched in which both principal and interest are in tune for inflation.
These bonds have a fixed real coupon rate which is functional to the inflation adjusted principal on each interest payment date.
On maturity, the higher of the face value or inflation adjusted principal is paid out to the investors.
Consequently, the coupon income as well as the principal is adjusted for inflation. The inflation adjustment to the principal is made by multiplying it with the index ratio.
The index ratio is calculated by dividing the reference index on the settlement date by the reference index on the date of issue of the security.
The Wholesale Price Index (WPI) is the inflation measurement that is observed for the calculation of the index ratio for these bonds.
An additionalclass of inflation-indexed instrument issued by the RBI for retail investors is the Inflation-Indexed National Saving Securities-Cumulative 2013.
These bonds of 10-year period were available to retail resident individuals, minors, HUFs, and charities among others.
The bond holds a fixed interest of 1.5% and an inflation rate calculated on the basis of the Consumer Price Index (CPI).
The interest is compounded every six months and cumulated and the same is payable with the principal on maturity.
The fixed rate of interest is the floor and ispayable even if there is devaluation. The interest is taxable in part to the tax status of the investors.